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Three things to know about Evidence Based Investing

Evidence Based Investing (EBI) is gathering more and more supporters and advocates around the world, and as a result is starting to appear quite frequently in investment commentary and indeed the mainstream media. It is a term that you may or may not be familiar with, so we’re taking the opportunity to inform you of what you need to know about it.

 

What is Evidence Based Investing?

EBI is an investing style grounded in academic research, the long-term observation of markets and how they actually work, while removing the need and the temptation for speculation and magic formulas in achieving investment success.

The EBI approach is based on the very best, peer reviewed empirical research, as opposed to the hunches and skill of active managers. It recognises that academic research tends to be independent in its nature, unlike much of the research produced in the fund management industry where commercial interests inevitably and often play a part in the direction of research findings. Academics simply don’t have anything to lose by concluding with findings that may be unfavourable for certain fund managers – they don’t have any “skin in the game”.

EBI also tends to be based on long-term data, which removes any skew in results from manipulating the dates in investment studies.

 

So what does all that mean in reality for investment portfolios?

The reality is that a tiny number of actively managed funds actually beat the market over a long period of time, when costs are included. Active fund managers each have good years and bad years, but very few of them consistently beat the market over the long term. And of course, just because they were good last year does not mean they will be good this year.

As a result EBI has become closely associated with and even intertwined with passive investing, where low cost index funds are used with minimal interventions that add cost. The goal is to achieve as close as possible to a market return. But why is it so hard to beat the market?

  • First of all, markets are efficient. All of the relevant news and information is generally available immediately and to all investors. It is very difficult for a manager to get an edge through unique knowledge. Also the millions of transactions that are happening each day are immediately built into share prices, again making it very difficult for managers to spot price anomalies and to exclusively act on them.
  • For active managers to achieve greater reward, they need to take more risk, have superior skill, have a large slice of luck or a combination of all three. Yes they will have wins from time to time, but they will also suffer times of under-performance.
  • Active managers have to carry out extensive research themselves, in order to gain an edge.  This costs money. If they are successful, active managers will also expect very large bonuses too, adding more cost. This reduces the gain for investors.

Yes, active management is more fun – the big bets, the unexpected wins, sometimes the above-average riches and the opportunities to appear to have had incredible foresight. It looks good when you’re popping the champagne! Passive investing on the other hand is, well a bit boring – but boring is often good and Evidence Based Investing definitely advocates this as a positive factor. Boring equals predictable and unexciting, positive attributes when it comes to your money.

However it is also worth noting that EBI is not always 100% aligned with simply tracking a series of indexes. Again based on academic research, some evidence-based fund managers have added their own flavour to portfolios in order to achieve outperformance. An example of this is a “tilt” towards smaller-cap value stocks.

 

Human behaviour is crucial

Active fund managers are humans. Similar to investors, their decisions can be clouded by a range of emotions – greed, fear, elation, despair and a range of biases that might cloud their judgement. Evidence Based Investing removes all of these.

But that is not to ignore how important your own behaviours are when it comes to investing. Base your decisions on the evidence available, think long-term and don’t try and time the markets. Don’t follow the latest fads and shut out all of the noise around you. The evidence shows that these behaviours will significantly increase your chances of success.